Wednesday, January 4, 2012

National debt is not normally a “burden” on future generations.

There’s been much debate recently on the net as to whether debt is a burden on future generations. It was sparked off by Krugman, who claimed that basically a burden cannot be imposed by the current generation on future generations. I agree (see here and here).

But see also: Noah Smith, and three Worthwhile Canadian Initiative posts, here,here and here. The debate seems to be inconclusive.

When trying to solve a problem, always cut out the extraneous, i.e. reduce the problem to its simplest form. Then add the extraneous if you like afterwards.

So let’s take a desert island with a few people living on it. Assume the island economy enjoys full employment and that for a currency, they use Cowrie shells. Assume “government” consists of a periodic meeting of islanders. Plus we’ll assume a closed economy to start with.

They decide one day that the island needs a pier for its fishing boats. So government borrows from those who feel like lending. Plus government imposes a tax on all islanders to fund interest on the bonds (and repayment of capital, if the bonds are to have a limited life).

The pier is built.

Now how does this impinge in the next generation? Well assuming bond holders donate their bonds to their offspring, there is no overall burden for the next generation because the children of bond holders inherit bonds (i.e. the right to receive interest and/or repayment of capital), while others inherit the obligation to pay taxes to fund interest on the bonds (and/or repayment of capital).

The assets and liabilities inherited cancel out. So as far as debt and bonds go, there is no net burden for future generations.

Moreover it is a plain impossible for any sort of “burden” to be endured in say 2030 that contributes to the building of the pier in 2012. To cut down a tree in 2030 and use the timber to build a pier in 2012 involves time travel, and that’s not on.

Inheriting investments.

Having said bonds as such do not cause a net cost or benefit for the next generation, the next generation do of course inherit the pier. So overall, far from their being a “burden” on the next generation, there is a BENEFIT for the next generation.

However, the latter “benefit” depends on government spending money on an investment, like a pier, rather than on a consumption item, like increased pay for the island’s police. In the latter case, there’d be no burden or benefit passed to the next generation.

Debt owed to foreigners.

An exception to the “no burden” rule occurs where government spending is funded by foreigners (As pointed out by R.A.Musgrave, in the American Economic Review in 1939. He is no relation.)

Obviously if the pier is built by people from some nearby island, who then demand repayment of the debt in X years time, then that is a real burden on the debtor island in X years time.

Pensions.

Another exception proposed by Nick Rowe, which I find unrealistic, would occur if the oldies in each generation managed to get youngsters to work extra hours and buy bonds off the oldies. (See Nick’s hypothetical “apple economy” here).

This actually occurs to some extent with pensions. That is, many people store up wealth (perhaps including government bonds) during their working life. They then effectively sell the bonds to younger people on retirement in that youngsters are storing up wealth to fund their own retirement. However, absent government bonds, people would make provision for their retirement ANYWAY. They’d just use different assets and/or they’d go for pay as you go schemes, or “unfunded” schemes as they are sometimes called.

The “different assets” obviously have a similar “getting youngsters to pay” effect as selling government bonds to youngsters. Same goes for pay as you go pension schemes, that is, in the case of these schemes, at any point in time, youngsters fund the pensions of oldies.

So when government incurs extra borrowing, there will be no burden on the next generation unless the effect of the extra borrowing is to increase the AGGREGATE amount that people decide they want by way of pensions. And personally I don’t see extra government borrowing having much of that sort of effect.

The interest less than GDP growth argument.

Another superficially attractive argument that features in the above mentioned debate arises out of the possibility that GDP growth exceeds the interest that government pays on bonds.Suppose interest is simply added to the debt. And assume that the bonds are very long term – i.e. centuries before maturity. In this scenario the liability that the bonds represent will ultimately decline to a negligible portion of GDP.From this it might seem that a government can borrow in 2012 and distribute goodies to its population, while the “payback” is essentially non-existent. It looks like a free lunch for people in 2012. (Incidentally, much the same superficially attractive argument applies where inflation erodes the value of bonds to near nothing in ten or twenty years time.)The flaw in that argument is of course that stuff produced in 2012 and distributed by government cannot be produced other than by blood, sweat and tears expended in 2012 (or earlier). There is no free lunch here. ______________

P.S. (23rd Jan). This argument has now gone viral. It’s generating more heat than light I think. It may well be what sparks off World War III. See the following: